A Primer on Exchange-Traded Funds

ETFs ENABLE INVESTORS TO TRADE “THE MARKET” with a single investment as easily as if they were buying an individual stock. Most ETFs are unit investment trusts and represent a portfolio of common stocks that closely track the performance of a specific index—either broad market, sector or international.

ETFs DIFFER FROM MUTUAL FUNDS in how shares or units are issued and redeemed and how they trade. ETF shares are created when an institutional investor deposits a specified block of securities with the fund. Individual retail investors can buy and sell shares only after they are listed on an exchange.

THE TAX IMPLICATIONS OF ETFs ARE IDENTICAL to those of ordinary stock. Since redemptions by large investors are paid in kind, an ETF is more tax efficient than ordinary mutual funds because it doesn’t have to sell stock at a gain to meet the redemption.

BECAUSE ETF SHARES ARE EASY TO BUY AND SELL, an investor should beware of the temptation to buy and sell too often, which could eliminate any tax or cost advantages. Clients who make regular trades may find the commissions overwhelming and be better off with traditional mutual funds.

An ETF is an index investment crossed with an exchange-listed corporate security and an open-ended mutual fund. They enable investors to trade “the market” with a single investment as easily as if they were buying an individual stock. ETFs represent ownership of a portfolio of common stocks that closely track the performance of a specific index, either broad market, sector or international. In an active secondary market, individual investors can buy or sell as little as a single ETF share during trading hours. By contrast, traditional mutual funds generally can be purchased or redeemed only at the end of the trading day.

ETF Assets on the Rise

At the end of 2000, overall exchange-traded fund assets totaled $65.6 billion, compared to $6.9 trillion for mutual funds. By October 2001, assets in exchange-traded funds had grown to $69.4 billion.

Source: Investment Company Institute, Washington, D.C., www.ici.org.

While an ETF is registered with the SEC as an investment company—either as an open-end fund or a UIT—it differs from a mutual fund both in how shares or units are issued and redeemed and in how they are traded. (See the exhibit at the end of this article.) Unlike mutual funds and UITs, ETF shares are created when an institutional investor (someone who manages money for institutions and corporate investors such as retirement plans or endowment trusts) deposits a block of securities with the ETF. In return for this deposit, the investor receives a fixed number of ETF shares, some or all of which it may then sell on a stock exchange.

The institutional investor can get its deposited securities back by redeeming the same number of ETF shares it got from the fund. (See “Creating an ETF” below for more details.) Individual investors can buy and sell ETF shares only when they are listed on an exchange. Unlike an institutional investor, an individual investor cannot purchase or redeem shares directly from the ETF as he or she could with a mutual fund.

Investors can buy ETFs on margin (subject to the same rules that apply to common stocks) at limit prices and sell them short in a brokerage account. Certain ETF products are even exempt from the rule that requires shares to be sold short only on an uptick in price. None of this holds true for a mutual fund.

Creation units. Unlike mutual fund distributors, ETF sponsors do not sell shares to the public for cash. Instead they exchange large blocks of ETF shares—called creation units—for the securities of the companies that make up the underlying index plus a cash component representing mostly accumulated dividends. Some institutional investors or wealthy individuals may hold the creation units in their own portfolios. Others, generally broker-dealers, break up the units and offer the ETF shares on the exchanges where individual investors can buy them in their brokerage accounts through a broker or an online trading account.

ETFs are redeemed in a way that is the opposite of how they are created. Broker-dealers buy enough ETF shares from individual investors to make a creation unit block. They then exchange the block with the ETF sponsor for a “basket” of securities and a small amount of cash. Other institutional investors simply trade back the creation units in their portfolio to the ETF sponsor for securities and cash.

Sponsors continually create and redeem creation units based on investor demand and for arbitrage purposes. An ETF’s value tracks closely but does not match exactly the value of the underlying security, so institutional investors can measure the price of the underlying securities in the index against the price of the ETF. If the price of the underlying securities is higher than the ETF, the institutional investors will trade a lower priced creation unit back to the sponsor in exchange for the higher priced securities. Conversely, if the price of the underlying securities is lower than the ETF, the institutional investor will trade the lower priced securities back to the fund in exchange for a creation unit. This arbitrage mechanism eliminates a problem sometimes associated with closed-end mutual funds—the fund’s trading for more or less than the value of the underlying portfolio.

THE TAX CONSEQUENCES

As with any investment, CPAs should consider the tax consequences of ETFs to individual investors. Essentially, the tax implications are identical to those for ordinary stock. If a client sells in less than one year, any gain will be taxed as ordinary income. If the client sells at a gain after a year, he or she will be taxed at lower capital gains rates. If the fund loses value, investors can write off the loss against other capital gains (and up to $3,000 annually of ordinary income) when they sell.

In taxable accounts, ETFs are more tax efficient than ordinary mutual funds. Investor sales can force mutual fund managers to sell stock to meet redemption requests. This can result in the fund’s paying a taxable capital gain to shareholders—even at a time when the overall market is trending down. In an ETF, nothing in the underlying portfolio changes when an investor buys or sells individual shares. Most trading takes place between shareholders. The fund doesn’t need to sell stock to meet redemptions so it avoids realizing a gain on its holdings. During periods of heavy redemptions, ETFs avoid selling the underlying stock holdings by transferring securities to redeeming shareholders, typically large investors or institutions. Because these investors are paid “in kind” with stock, not cash, other shareholders are protected from a taxable event. However, ETFs can and do make capital gains distributions. These usually result when the ETF must buy and sell stocks to adjust for changes in its underlying benchmark (the index the ETF tracks).

Current shareholders of mutual funds pay taxes on distributions, while former shareholders—who may have benefited from the gains that created the distributions—do not. ETFs, on the other hand, use a swapping feature to eliminate embedded capital gains from the portfolio. Each security the ETF holds has a tax basis, and the fund distributes the lowest-cost-basis securities in its portfolio during the redemption process. The redeeming investor is responsible for taxes, and the ETF ends up with a higher-tax-basis portfolio and fewer capital gains to distribute—reducing capital gains exposure for investors when the fund must sell a particular stock during rebalancing. Whenever an investor redeems a basket of securities, the fund gives that redeemer the lowest-cost-basis stock. It doesn’t matter to the redeemer, which pays taxes based on its individual cost basis, not the basis of the underlying stock.

TOO GOOD TO BE TRUE?

So what’s the catch? Is there a downside for investors CPAs should know about? To begin with, greater tax efficiency doesn’t necessarily mean 100% tax efficiency. ETFs still pay out dividends and any gains that arise from changes in the composition of the indexes they track—just as open-end mutual funds do. While some ETFs—such as Qubes—have made few or no distributions so far, others make distributions annually.

The biggest catch for investors stems from one of the major attractions of these funds—that they can be bought and sold so easily by calling a broker or accessing an online trading account. An investor who is tempted to buy and sell often could eliminate any tax or cost advantages. Unfortunately, statistics suggest ETF investors are doing just that. While the typical mutual fund is held three years, the average holding period for SPDRs in the first five months of 2001 was just 19 days and for Qubes only 4 days. In addition, share prices can diverge from the fund’s net asset value and trade at a premium or a discount—which means a buyer could end up paying more for shares than they were worth. Combined with a brokerage commission, this could negate the lower expenses. In summary ETFs are a good idea for index investors but, just as with mutual funds, CPAs should recommend them only as part of a balanced portfolio and advise clients to acquire them on a long-term, buy-and-hold basis.

Some investors never should use ETFs: If a client makes periodic investments or periodically rebalances his or her portfolio, he or she could end up being “eaten alive” by commissions. From a cost perspective the client would be better off with a mutual fund. If he or she plans to make a single large investment, assuming a low commission (on the buy and sell transactions), CPAs may want to do the math to determine whether the client would be better off putting that money in an index mutual fund.

THE BOTTOM LINE

Why are ETFs so hot? In a nutshell, they are easy to buy, inexpensive to own and tax efficient. Unlike mutual funds, they can be bought and sold throughout the day at real-time prices, sold short and purchased on margin. They can be bought through any broker, which means an investor can further control his or her expenses by using a discount broker. In advising clients, CPAs should caution them to beware of steep sales charges. Initial charges and exit fees typically amount to 2% to 5%. But annual operating expenses are very low. Compare Qubes with an expense ratio of .18% to Rydex OTC, a mutual fund that also seeks to track the Nasdaq 100, at 1.15%, or Vanguard’s Index 500 Trust at .18% with Barclay’s iShares S&P 500 fund at .0945%. ETFs can be significantly more tax efficient than open-end mutual funds because they aren’t subject to the cash flow fluctuations. This is helping generate significant investor interest in this relatively new investment vehicle.

When the mad hatter is running the tea party, the best CPAs can do is follow the white rabbit and recommend ETFs where appropriate. But don’t let the excitement of the moment replace good judgment. Once CPAs have completed the asset allocation portion of the financial planning process, they can help clients select a mix of ETFs that meet their goals, risk tolerance and time horizons.

Is there an ETF in your clients’ future? ETFs initially will cut more into sales of individual securities than mutual funds, at least on the retail side. Mutual fund buyers tend to be conservative buy-and-hold investors who don’t have brokerage accounts. It will take time for them to become ETF-savvy, whereas those who actively purchase individual securities will find it more natural to buy ETFs. But perhaps the most interesting angle is that ETFs will bring passive investing to active securities investors.